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Euro Bears Emboldened

Not since before the global financial crisis have Europe’s banks been able to obtain dollars as cheaply as they can now, a development that may puncture the euro’s surprising strength.

The cost of swapping euro funding streams for those in dollars to service foreign loans fell this year to the lowest since January 2008, data compiled by Bloomberg show. The cross-currency basis swap has shrunk from a three-year high reached in 2011 as Europe’s banks focused on shrinking their balance sheets instead of expanding abroad.

“Since the basis swap has now normalized, it signals the deleveraging that has been the key to the euro’s strength may have largely run its course,” Chris Walker, a foreign-exchange strategist at Barclays Plc in London, said in a Feb. 19 phone interview. “The drivers of the currency will return to relative monetary-policy divergence.”

The euro strengthened 4.2 percent last year versus the dollar even after the European Central Bank (ECB) cut interest rates twice. The gains defied the median prediction of strategists surveyed by Bloomberg, who saw it dropping to $1.27 from $1.3193 at the end of 2012. Instead, it rose to $1.3743 on Dec. 31, before trading at $1.3765 as of 9:07 a.m. in London.

Europe’s common currency has been supported by lenders rushing to deleverage before the European Central Bank completes an audit of their assets in November. Traders betting against the euro may now get some relief amid speculation the ECB will ease monetary policy further while the U.S. Federal Reserve pares its stimulus. Such measures tend to weaken a currency because they add to supply.

ECB President Mario Draghi said after a Group of 20 meeting in Sydney yesterday that policymakers are ready to add to stimulus if the outlook for prices deteriorates, though there are currently no signs of deflation in the euro area.

The euro-zone economy is forecast to grow 1 percent in 2014, lagging behind the U.S.’s 2.9 percent, according to the median estimate of Bloomberg analyst surveys.

“The market may start to focus on that domestic weakness in Europe,” Ken Dickson, an Edinburgh-based director for foreign exchange at Standard Life Investments Ltd., said in a Feb. 19 phone interview. Scotland’s second-biggest money manager, with about $297 billion of assets, sees “fair value” for the euro at $1.29, Dickson said.

Shrinking Basis

The one-year cross currency basis swap shrank to 2.75 basis points below the euro interbank offered rate (Euribor) on Jan. 16, and was at 4.9 basis points under the benchmark at the end of last week, Bloomberg data show. The rate was 4.8 basis points below Euribor at 8:31 a.m. New York time.

That compares with an average of 14 basis points below Euribor since the euro’s 1999 debut and a post-crisis peak of 107 basis points under in December 2011. A swap rate below Euribor shows traders are paying a premium to exchange euro-based cash flows for those in dollars, and a basis point is 0.01 percentage point.

The euro climbed 8.2 percent against a basket of 10 developed-nation currencies in 2013, the best performance in the group, Bloomberg Correlation-Weighted Indexes show. This year, it has stalled, rising just 0.03 percent versus its peers. It’s little changed against the dollar this year, though in February it has done better, gaining 1.8 percent versus the greenback.

“The growth divergence between the U.S. and Europe is going to be something that helps push the dollar higher,” Mitul Kotecha, the Hong Kong-based global head of foreign-exchange strategy at Credit Agricole SA, said in a Feb. 21 phone interview. He expects the euro to slip to $1.27 in a year.

Europe’s 23 biggest listed banks cut their assets by 11 percent to 20.9 billion euros ($29 billion) at the end of the third quarter, from 23.4 billion euros a year earlier, data compiled by Bloomberg Industries show. The figure includes lenders from countries that don’t use the euro.

Euro-area bank claims on foreigners, including securities and loans, have declined about 10 percent since the end of 2011, according to an analysis of ECB data by Barclays.

Banks have cut assets since the outbreak of the euro region’s sovereign-debt crisis in 2009 as they sought to comply with regulators’ stricter requirements for capital buffers against bad loans. The ECB is due to complete its asset quality review, or AQR, of lenders by November, when it assumes oversight of the 128 biggest banks from national regulators.

The euro has also been supported as banks started repaying about 1 trillion euros of emergency loans provided by the ECB under two longer-term refinancing operations, or LTROs, in December 2011 and February 2012. That helped shrink the ECB’s balance sheet to 2.19 trillion euros on Feb. 14, from a peak of 3.1 trillion euros in June 2012.

ECB’s Options

ECB officials, who next meet to set interest rates on rates March 6, are debating whether they should ease monetary policy to boost the economy and spark inflation that’s less than half their 2 percent target.

Options include cutting the refinancing rate from its record-low 0.25 percent, ending the mopping-up of excess liquidity from the ECB’s crisis-era bond purchases, or emulating their U.S. counterparts and printing money.

While investors aren’t expecting the Fed to raise rates anytime soon, the U.S. is reducing its bond-purchase program as the economy improves, which may bolster the dollar. The central bank has tapered its bond purchases to $65 billion a month from an initial $85 billion, and Chairman Janet Yellen pledged Feb. 11 to keep scaling back the program in “measured steps.”

The median prediction of more than 60 analysts is for the euro to depreciate to $1.32 by June 30 and $1.28 by December. Michael Sneyd, a currency strategist at BNP Paribas SA, is more bearish, predicting a drop of about 8 percent to $1.26 by the end of this year as investors’ focus turns to monetary policy.

“Deleveraging has probably mostly run its course,” London-based Sneyd said in a phone interview on Feb. 21. “It was a particular focus at the end of last year ahead of the AQR. That did cause a lot of euro buying, particularly in December as people brought forward that deleveraging process. This year, I’d say it’s less on investors’ radar.”

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